Recent Developments in Estate Planning: Part 1

This is the first in a two-part article examining developments in estate, gift, and generation-skipping transfer (GST) tax and trust income tax between June 2013 and May 2014. Part 1 discusses gift, estate, and GST tax developments. Part 2, which covers trust developments, the taxation of trusts under the new 3.8% net investment income tax, President Barack Obama’s estate and gift tax proposals, and inflation adjustments for 2014, will be published in the October issue.

Gift Tax

Valuation

Under Sec. 2035(b), the amount of the gross estate includes any gift tax paid by the decedent within three years before the decedent’s death. In Steinberg,1 the Tax Court denied the IRS’s motion for summary judgment and concluded that, for gift tax purposes, a donor could reduce the value of gifted property by the value of the donee’s assumption of the donor’s potential Sec. 2035(b) estate tax liability.

On April 17, 2007, the 89-year-old donor entered into a binding gift agreement with the donees, her four children. In the agreement, the donees assumed liability for any gift tax imposed on the donor’s gift—a “net gift” arrangement in which the value of the gift is reduced by the value of the gift tax liability the donees assumed. The donees also agreed to assume any liability for the Sec. 2035(b) estate tax due if the donor died within three years of the date of the gift—a “net, net gift” arrangement.

On Oct. 15, 2008, the donor filed a timely gift tax return based on an appraisal that valued the net gift at approximately $71.6 million and the actuarial value of the donees’ assumption of the potential Sec. 2035(b) estate tax liability at approximately $5.8 million. The IRS denied the donor’s discount for the donees’ assumption of the potential tax liability and issued a notice of deficiency. After the donor filed a Tax Court petition, the IRS responded with a motion for summary judgment asserting that the donees’ assumption of the potential tax did not constitute consideration for purposes of determining the value of a net gift.

Under Sec. 2035(b), if a decedent dies within three years of paying any gift tax, the gift tax is included in the decedent’s estate. A “net gift” is a gift in which the donee assumes responsibility for payment of the gift tax imposed on the transfer. The donor calculates her gift tax liability by reducing the value of the gift by the gift tax liability the donee assumed, because the assumption of the gift tax liability is treated as consideration, converting a net gift into part gift and part sale.

The IRS argued that the donees’ assumption of the potential Sec. 2035(b) taxes was worthless and provided no monetary benefit to the donor. As such, the donees’ assumption of potential tax failed as consideration under the “estate depletion” theory, which stands for the proposition that the amount of consideration in a gift transaction is measured by the benefit to the donor in money or money’s worth.

The donor’s argument rested on the Fifth Circuit’s decision in Succession of McCord.2 In McCord, the taxpayers gifted limited partnership (LP) interests to their sons who agreed to be liable for any transfer taxes on the gifts, including gift tax, estate tax, or GST tax. The taxpayers reduced the value of the gift to their children by the actuarially determined value of the sons’ contingent obligations to pay any estate tax. The Tax Court agreed with the IRS that the taxpayers could not reduce the value of their gift by the value of the sons’ obligations to pay any potential estate taxes arising from the transaction because no recognized method exists for approximating the estate tax liability with a sufficient degree of certainty. In addition, the Tax Court suggested that the taxpayers’ reduction of the value of their gift failed under the estate-depletion theory because, if the donee paid any estate tax imposed by Sec. 2035, the payment would benefit the donor’s estate (and the beneficiaries) rather than the deceased donor.

The Fifth Circuit reversed the Tax Court, holding that nothing was so speculative about the sons’ assumption of the potential Sec. 2035(b) estate tax liability that would prohibit valuing that liability. Generally, the value of a gift is the price at which the property would change hands between a willing buyer and willing seller. Although it was not certain that the donor would die within three years of making the gift, a willing buyer would insist on the willing seller’s recognition of the three-year exposure to Sec. 2035 estate taxes be taken into account in valuing the gift. As such, the Fifth Circuit determined that the assumption of the potential Sec. 2035 estate tax liability was not so speculative that it was worthless.

In Steinberg, the Tax Court agreed with the Fifth Circuit’s decision in ­McCord and concluded that the donees’ assumption of the potential Sec. 2035(b) estate tax liability may be treated as consideration reducible to a monetary value that reduces the value of the donor’s gift. The Tax Court also reexamined its previous analysis of the issue in McCord.

First, the Tax Court looked at Robinette v. Helvering,3 in which the Supreme Court held that the value of a contingent reversionary remainder interest of property in trust could not reduce the value of the gift in trust because there was no recognized method to value the interest. Robinette involved a complex contingency in which the reversion of property to a mother depended on the mother’s surviving her unmarried daughter and the unmarried daughter’s dying without issue before the age of 21. The Supreme Court distinguished this complex remainder interest from a simple contingent remainder based only on survivorship, noting that a simple contingent remainder could be valued actuarially. The Tax Court found that the contingency at issue was a simple contingency based only on survivorship.

The Tax Court also concluded it is possible to determine the amount of a potential Sec. 2035(b) estate tax liability using the rates and exemptions on the date of the gift even though estate tax rates and exemption amounts are subject to change. It pointed out that with respect to the capital gains tax, many courts have held that the fair market value (FMV) of gifts or bequests of stock must be reduced by the potential tax liability on the built-in capital gains on the valuation date, even though the tax will not be paid until an unknown time in the future and the capital gains rates have changed many times.

The Tax Court further noted that it incorrectly analyzed the estate-depletion theory in McCord because it distinguished between a benefit accruing to the donor versus a benefit accruing to the donor’s estate. In Steinberg, the court found that for purposes of the estate-depletion theory, the donor and the donor’s estate are not separable. Under the estate-depletion theory, whether a donor receives consideration is measured by the extent to which the donor’s estate is replenished by the consideration. Because a donee’s assumption of a Sec. 2035(b) estate tax liability may provide a benefit to the donor’s estate, the court determined that the donee’s assumption may satisfy the estate-depletion theory.

The Tax Court next addressed the IRS’s argument that the assumption of the Sec. 2035(b) liability should not reduce the value of the donor’s gift but, instead, should be treated as a gift from the donees to the donor. The IRS argued that any transfers between family members are necessarily treated as gifts unless it is shown that the transfers were made in the ordinary course of business. The court rejected this argument and pointed out that a transfer between family members is not a gift to the extent it is made for consideration in money or money’s worth even if the transfer is not in the ordinary course of business. In conclusion, the court denied the IRS’s motion for summary judgment.

The opinion was a fully reviewed opinion. Seven of the Tax Court judges concurred with the court’s opinion, and six of the judges concurred in the result only. One judge dissented. This case presents an opportunity for donors to reduce the value of their gifts using the net, net gift approach. In this particular case, the amount of the estate tax contingency reduced the value of the gift by $5.8 million.

Estate Tax

Basis of Inherited Property

Under Sec. 1014(a)(1), the tax basis of inherited property is usually its FMV at the date of death. However, when a Sec. 2032A special-use valuation is elected, Sec. 1014(a)(3) provides that the property’s tax basis is its special-use value instead of its FMV. The estate tax benefit of this election is that the value of the property included in the gross estate is determined by valuing it in its actual use at the time of death, rather than in its highest and best use. In Van Alen,4 the beneficiaries, who received property from their father’s estate for which a Sec. 2032A election had been made, ignored the special-use valuation when they sold the property and instead reported their gain using the highest-and-best-use valuation as of the date of the decedent’s death.

When he died, the decedent owned a fractional interest in a family farm. He left most of his estate (including the interest in the farm) to a testamentary trust whose beneficiaries were his two children from his second marriage, a daughter age 18 and a son age 14. California probate law requires a county “probate referee” to appraise a decedent’s real property subject to probate, and this probate referee valued the farm at $1.963 million. The executor, however, elected a special-use valuation for the farm, and reported a value of $144,823 on the estate tax return (later reduced to $98,735). As required by Sec. 2032A(d)(2), the executor, the daughter, and the decedent’s second wife, who was guardian for the minor son and trustee of the trust, executed an agreement binding them to the requirements under Sec. 2032A(c) (which imposes additional estate tax on special-use valuation property if it is disposed of or fails to be used for its special use within 10 years of the decedent’s death).

Almost 10 years after the father’s estate tax return was filed, a conservation easement on the farm was sold for $1.12 million. The trust’s share was $910,000. After subtracting various trust-level deductions and the basis in the farm of $98,735, the trust reported almost $720,000 in income from the transaction, distributed it to the beneficiaries, and sent Forms 1041 K-1, Beneficiary’s Share of Income, Deductions, Credits, etc., to each beneficiary reporting trust income of $360,000. The trust subsequently filed an amended return reporting a basis of double the original basis and reducing the income reflected on the K-1s to each beneficiary to $310,000.

After the beneficiaries did not report the trust income on their personal income tax returns, the IRS issued notices of deficiency. Most of the deficiency was attributable to the failure to report the capital gain from the conservation easement transaction. The beneficiaries’ main argument was that their tax bases in the interest in the farm were much higher than the bases the trust used, and they hired the probate referee who had originally valued the interest in the farm at $1.963 million (but later said the proper basis was $900,000) as an expert.

The Tax Court first considered the beneficiaries’ argument that, under Rev. Rul. 54-97, they were not bound by the value of the interest in the farm listed on their father’s estate tax return. The revenue ruling held that, when determining a property’s basis, the value of the property as determined for estate tax purposes is deemed to be its FMV at the time of acquisition but, except where the taxpayer is estopped by his previous actions or statements, this value is not conclusive but may be rebutted by clear and convincing evidence. The beneficiaries argued that the probate referee’s appraisal of $1.963 million was clear and convincing evidence that someone made a serious mistake when reporting the special-use value at less than $100,000. As a result, they requested the Tax Court to redetermine the special-use valuation, not to increase their father’s taxable estate, but only to recalculate the trust’s tax basis in the farm interest. The Tax Court declined to address their argument that the revenue ruling applied, because it had determined that the beneficiaries were bound by the duty of consistency since they had consented to the special-use valuation on the estate tax return.

The duty of consistency in the tax treatment of assets derives from the Ninth Circuit decision in Janis.5 In that case, the Ninth Circuit listed conditions that the court must find to invoke the duty of consistency: (1) a representation by the taxpayer; (2) reliance by the IRS; and (3) an attempt by the taxpayer, after the statute of limitation has run, to change the previous representation or to recharacterize the situation in a way that harms the IRS. The major disagreement in the present situation was the applicability of the first condition. The beneficiaries’ primary argument was that they did not make a representation on which the IRS relied but rather only the executor of the estate made the representation.

Following case law, the Tax Court concluded that the duty of consistency encompasses parties with sufficiently identical economic interests, including beneficiaries of an estate. The Tax Court found that the beneficiaries, as well as their father’s estate, benefited from the position taken by the executor. Thus, the court found that the economic interests of the beneficiaries and the executor were sufficiently identical and the Sec. 2032A value should be used to determine the tax basis of the beneficiaries. To rule otherwise would have allowed the beneficiaries to profit both from the position taken on the estate tax return (receiving a substantially larger bequest), as well as from the position taken on their income tax returns (recognizing substantially less income), effectively benefiting twice from inconsistent positions relating to the same property. Therefore, the court determined that the duty of consistency required the beneficiaries to use the special-use value as their tax bases.

The technique of using a different valuation for estate tax purposes than for other tax purposes would expressly be prohibited if the president’s tax proposals are enacted. The president’s 2015 budget includes a provision that would bind beneficiaries who receive property from a decedent to the basis as determined by the value of the property listed on the decedent’s estate tax return (see Part 2 of this article in the October issue for more detail on the proposal).

Estate Inclusion of QTIP

Sec. 2044 requires an estate to include in the gross estate the value of any property in which the decedent had a qualifying income interest if a marital deduction was allowed under Sec. 2056(b)(7) with respect to the transfer of the property to the decedent. Estate of Olsen6 teaches a valuable lesson about properly funding marital trusts so that the amount required to be included in the surviving spouse’s estate under Sec. 2044 is properly determined.

The taxpayer created a revocable trust and appointed himself as trustee. On the same date, his wife created a revocable trust with identical terms and appointed the taxpayer as trustee. The terms of his wife’s trust directed that, if the taxpayer survived her, the trustee was to transfer the assets in the wife’s trust to (1) a marital trust that in turn was to be divided into two separate trusts known as Marital Trust A and Marital Trust B and (2) a separate trust known as the Family Trust. The governing instrument of each revocable trust gave the trustee the power to (1) distribute principal from the Family Trust to charitable organizations (via a special power of appointment given to the surviving spouse) and (2) distribute principal from Marital Trust A and Marital Trust B for the surviving spouse’s health, education, support, and maintenance.

When the wife died before the taxpayer, he filed a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, for his wife’s estate, reporting that his wife’s trust held $2,104,695 in assets on the date of her death and those assets were to be distributed as follows: (1) $1 million to Marital Trust A; (2) $504,695 to Marital Trust B; and (3) $600,000 to the Family Trust. However, during the taxpayer’s lifetime, he did not segregate his wife’s trust into three separate and distinct trusts, nor did he fund those trusts, as required by the terms of the wife’s trust. Moreover, the taxpayer made three significant withdrawals from his wife’s trust totaling $1,474,780 ($249,550 and $831,252 for charitable contributions and $393,978 that he deposited in his personal account).

After the taxpayer’s death, his son, the taxpayer’s estate’s personal representative and successor trustee, did not find any records to indicate (1) whether the taxpayer had made the withdrawals under a particular provision or authority granted in his wife’s trust or (2) from which trusts the withdrawals were made. The answers to these questions would establish whether certain remaining assets in the wife’s trust would be includible in the taxpayer’s gross estate. Assets allocable to Marital Trust A and Marital Trust B were includible in the taxpayer’s gross estate, while assets in the Family Trust were not.

On the Form 706 for the taxpayer’s estate, the son did not include any portion of the value left in the wife’s trust at the taxpayer’s death because the son believed that the taxpayer’s withdrawals depleted Marital Trust A and Marital Trust B, and whatever was left in his mother’s trust was allocable to the ­Family Trust. The IRS, however, disagreed and issued a notice of deficiency, including all of the value in the wife’s trust as of the date of the taxpayer’s death in his gross estate. In the IRS’s view, the Family Trust did not hold any assets from the wife’s trust on the date the taxpayer died. Therefore, all the assets in the wife’s trust were allocable to Marital Trust A and Marital Trust B and includible in the taxpayer’s estate.

The Tax Court accepted the fiction that Marital Trust A, Marital Trust B, and the Family Trust had been funded before the taxpayer’s withdrawals and agreed with the IRS that the first two withdrawals for charitable reasons ($1,080,802) should be considered to have been made from the Family Trust. The court agreed with the estate that the last withdrawal for personal reasons should be considered to have been made from the marital trusts. Based on the terms of the wife’s trust, the court held that the wife’s intent was to provide the taxpayer with the authority as her surviving spouse to (1) appoint principal from the Family Trust to one or more charitable organizations (partially agreeing with the IRS) and (2) to pay to or apply for his benefit principal from Marital Trust A and Marital Trust B as advisable to provide for his health, education, support, and maintenance (partially agreeing with the estate). The amounts remaining in the wife’s trust, after allocating the withdrawals among Marital Trust A, Marital Trust B, and the Family Trust, were includible in the taxpayer’s estate under Sec. 2044.

The Tax Court probably came to the correct conclusion based on the taxpayer’s powers as trustee and surviving spouse of the separate trusts under his wife’s trust agreement. However, it should not have come to this. The proper funding of testamentary trusts within a reasonable time after the estate is wound up (or in the case of a revocable trust, within a reasonable time after the death of the settlor) is critical to the estate planning process. It is doubtful that the taxpayer was properly distributing the net income from Marital Trust A and Marital Trust B as required under Sec. 2056(b)(7) to afford his wife’s estate a marital deduction. Had the IRS audited the wife’s trust before the statute of limitation ran on her estate tax return, the Service probably would have disallowed the marital deduction her ­estate claimed. An estate plan is worthless if the players do not understand their roles or simply ignore them. Although the result in Olsen was favorable, the estate still had to go through the time and expense of an audit and litigation. Had the taxpayer properly fulfilled his role as trustee, this case would have never arisen.

Installment Payments

In Letter Ruling 201403012, the IRS ruled that a pro rata distribution of real estate owned by closely held businesses to a decedent’s estate and the subsequent contribution of the property to limited liability companies (LLCs) his estate owned did not result in the acceleration of estate tax installment payments under Sec. 6166.

The decedent died owning a greater than 20% interest in several closely held general partnerships, LLCs, and corporations that owned interests in commercial real estate. The decedent’s executors timely filed a Form 706 and elected to defer the payment of estate tax attributable to the decedent’s interests in the various businesses. One of the businesses in which the decedent had an interest was a general partnership (GP). At the time of his death, the decedent and his family members owned commercial real property interests as tenants-in-common as nominees for GP. The decedent’s interest in GP represented more than 50% of the total value of the closely held businesses reported on the decedent’s estate tax return.

Subsequently, the decedent’s estate and his family members proposed to restructure GP by distributing its commercial properties pro rata to its partners (i.e., the decedent’s estate and his family members), followed by the decedent’s estate and his family members contributing their respective properties to separate LLCs for each property. Afterward, the decedent’s estate and his family members would own each LLC pro rata based on the amount of their respective contributions of property to each LLC, and each LLC would continue the active business GP previously conducted. At no point during the restructuring would the decedent’s estate or his family members withdraw money or other property from the GP.

The decedent’s estate requested a ruling that neither the distribution from GP to the decedent’s estate nor the subsequent contribution of each property to the LLC would constitute a distribution, sale, exchange, or other distribution within the meaning of Sec. 6166(g)(1) and would not result in the acceleration of the estate tax installment payments under Sec. 6166(a).

Sec. 6166(a)(1) allows an elective deferral of the estate tax if a decedent owned, at the time of death, an interest in a closely held business whose value exceeded 35% of the decedent’s adjusted gross estate. This provision allows an executor to pay the estate tax in two or more but no more than 10 equal installments. Furthermore, the first installment payment may be deferred up to five years from the date the estate tax is due. Sec. 6166(c) provides that for purposes of applying the 35% threshold test, various closely held business interests may be aggregated whenever 20% or more of the total value of each interest is included in the decedent’s gross estate.

Sec. 6166(g)(1)(A) provides that the extension of time will cease to apply if (1) any portion of an interest in a qualified closely held business that qualifies for the Sec. 6166(a)(1) election is distributed, sold, or otherwise disposed of, or money or other property attributable to that interest is withdrawn from the trade or business; and (2) the aggregate of those distributions, sales, exchanges, or other dispositions and withdrawals equals or exceeds 50% of the value of the trade or business. If this occurs, the unpaid portion is due and payable upon notice and demand by the IRS. Regs. Sec. 20.6166A-3(e)(2) provides that the phrase “distributed, sold, exchanged, or otherwise disposed of” is broad in scope. However, Rev. Rul. 66-62 concluded that where a change in the operation of a business from a corporate form to an unincorporated form does not materially alter the business or the interest of the estate in the business, the change does not cause a termination of the installment privilege.

The IRS concluded that the proposed transaction did not materially alter the business of GP and that there would be no withdrawal of money or other property. It further concluded that, after the transaction, the decedent’s estate would own the same proportionate interests in the assets of GP through its proportionate ownership interest in each LLC. Therefore, the IRS concluded that the proposed transaction would not trigger application of Sec. 6166(g)(1) and, consequently, it would not accelerate the estate’s installment payments under Sec. 6166(a).

Incidents of Ownership

Under Sec. 2042, proceeds from a life insurance policy on the life of a decedent may be included in the value of his or her gross estate in certain circumstances. These circumstances include when the proceeds of a policy on the decedent’s life are (1) payable to the decedent’s executor; or (2) payable to beneficiaries of the decedent’s estate if the decedent (either alone or with another person) possessed any “incidents of ownership” over the policy at the time of death. Regs. Sec. 20.2042-1(c) provides that “incidents of ownership” are not limited to direct legal ownership but encompass the right to the economic benefits of the policy, which include, but are not limited to (1) a power to pledge the policy for a loan; (2) a power to change a beneficiary; (3) the possession of a purchase option; (4) a power to surrender or cancel a policy; (5) a power to assign a policy; and (6) a reversionary interest in the policy if the value of such interest exceeds 5% of the policy’s value immediately before the decedent died.

Some life insurance policies pay dividends to policyholders. In these situations, participating policy owners pay premiums to the insurance company in exchange for a death benefit protection like most other plans, but the policy also accumulates a guaranteed cash value. After paying claims, expenses, and other liabilities, and funding the policy reserves used to provide for future benefits, the insurance company determines how much should be distributed to policy owners in the form of a dividend. In Chief Counsel Advice 201328030, the IRS concluded that the retention of the right to policy dividends is not an incident of ownership for purposes of Sec. 2042.

Before he died, the decedent and his wife had divorced and executed a property settlement agreement, which required him to maintain life insurance policies on his life for his ex-wife’s benefit. He was not permitted to borrow against or pledge the policies, but the policy dividends belonged to him. Upon his death, the insurance company paid the policy proceeds to the ex-wife.

The IRS stated that the decedent’s right to the policy dividends was not itself an incident of ownership for federal estate tax purposes, so the value of the proceeds was not includible in the decedent’s federal gross estate. In so concluding, the IRS cited the Tax Court’s decision in Estate of Bowers7 in which a decedent agreed to maintain life insurance on his life with the proceeds payable to his ex-wife as part of a divorce settlement. The decedent reserved both (1) a reversionary interest worth less than 5% of the value of the policy; and (2) the right to the policy dividends, which could be applied against the premiums. The court held that the decedent’s right to receive dividends that could only be applied against a current premium was a reduction in the amount of premiums paid rather than a right to the policy’s income.

The IRS seems to be making a pretty broad statement regarding policy dividends in applying an old Tax Court case. Bowers was decided in 1955, when life insurance policies were generally not used as investment vehicles. Given the array of life insurance policies available and their increasing use as investment vehicles, practitioners should be cautious about a blanket statement that a policy dividend is a “rebate” in all instances, especially if the dividend is larger than the actual policy premiums paid in any given year or is paid after the policy is paid up.

Deduction for Uncertain Litigation Claims

Under Sec. 2053(a), the value of a taxable estate is determined by deducting certain amounts (such as funeral and administration expenses) from the value of the gross estate. Sec. 2053(a)(3) allows a deduction for claims against a decedent’s estate. Neither Sec. 2053(a) nor the regulations contain a method for valuing a claim against an estate, and the courts have been inconsistent about the extent to which post-death events are to be considered in valuing these claims. In general, the court decisions have floated between one line of cases that follows a date-of-death valuation approach and another line of cases that restricts deductible amounts to those amounts the estate actually paid to satisfy a claim.8 Final regulations, effective for estates of decedents dying after Oct. 20, 2009, reflect the IRS’s rejection of the date-of-death valuation approach and adoption of rules based on the premise that an estate may deduct only amounts actually paid in settlement of claims against the estate.9 The final regulations “clarify” that events occurring after a decedent’s death are to be considered when determining the amount deductible under all provisions of Sec. 2053 and that those deductions are limited to amounts the estate actually paid in satisfaction of deductible expenses and claims.

In Estate of Saunders,10 the Ninth Circuit affirmed the Tax Court’s decision11 that post-death events could be considered in valuing a legal malpractice claim pending against the decedent at the time of his death. The Ninth Circuit and the Tax Court applied the prior regulations that were in effect at the date of the decedent’s death. Under Regs. Sec. 20.2053-1(b)(3), a deduction for a claim may be taken even though its exact amount is not known, provided it is ascertainable with reasonable certainty and will be paid. However, no deduction may be taken for a vague or uncertain estimate. That regulation section also provides that if a liability that is not deductible because it is not ascertainable subsequently becomes ascertainable, a deduction may be claimed at a later time.

In Saunders, the decedent’s estate had a pending claim against it stemming from a malpractice suit against the decedent’s previously deceased spouse, claiming damages of $90 million. The estate valued the malpractice claim at $30 million based on an appraisal from the attorney handling the malpractice suit, but the claim was later settled for $250,000. The IRS challenged the valuation and allowed a deduction of $1. The estate later obtained two additional valuations of the malpractice claims that valued the claims at $19.3 million and $22.5 million.

The Tax Court discussed the difference between valuing an asset versus valuing a liability in the decedent’s estate. A claim that is an asset can be valued using recognized methods by assuming various outcomes, assigning probabilities to those outcomes, and quantifying the results. A stricter valuation standard applies to a claim that is a liability because the regulations require that the claim be “ascertainable with reasonable certainty.”12 The court noted that the appraisals from the three experts varied widely in methodology and did not address whether the amount would actually be paid. The Tax Court concluded that the claim was not ascertainable with reasonable certainty and would be deductible only when actually paid. As a result, the $30 million deduction claimed on the estate tax return was reduced to the $250,000 amount actually paid, plus the $289,000 cost of litigation.

The Ninth Circuit noted that it had applied Regs. Sec. 20.2053-1(b)(3) on numerous occasions and classified these claims as either “certain and enforceable” or “disputed and contingent.” When claims are certain and enforceable, post-death events are not relevant, but when claims are disputed and contingent, post-death events are relevant. In this case, the claim was disputed at the time of the decedent’s death and, therefore, the Tax Court had properly considered post-death events in computing the allowable deduction.

Valuation for Built-in Capital Gains Tax

In Estate of Richmond,13 the Tax Court has returned to its present-value concept to determine the discount for built-in capital gains (BICG) tax when valuing an interest in an entity for estate tax purposes. The discount for the BICG tax is founded upon the premise that a hypothetical buyer, in determining the price he or she would pay for an interest in an entity, would take into consideration the tax on the capital gain inherent in an entity whose assets’ FMV meaningfully exceeds its tax bases compared to an entity whose assets’ FMV approximates its tax bases. The discount is applicable when the best estimate of an entity’s value is based upon the net-asset-value (NAV) method for valuation. While the case law is clear that this discount applies when an entity’s value is based upon the NAV method, the cases are much less clear on the method for determining the amount of the discount.

The decedent died owning a 23.44% interest in a family-owned personal holding company (PHC). PHC’s assets were publicly traded securities totaling $52,159,430 as of the date of the decedent’s death. The decedent’s interest was worth $12,215,531 on that date. PHC’s 76-year-old tradition had been to hold investments for future gains and dividend accumulation. The average annual turnover of PHC’s portfolio was 1.4%, which would require 71 years for a complete turnover. As a result, 87.5% of the value of its portfolio ($45,576,677) consisted of appreciation on which capital gain tax had not yet been paid. For this reason, PHC’s total BICG tax liability would have been $18,113,083 had all the assets been sold on the date of the decedent’s death.

The decedent’s estate filed an estate tax return showing the value of $3,149,767 for the decedent’s interest in PHC. The estate’s expert used the capitalized-dividend method to arrive at this value. This method is based on the theory that if an asset produces a predictable income stream, the market value of the asset can be ascertained by calculating the present value of that future income stream. The IRS, instead, used the NAV approach, arriving at a value of $9,223,658, and asserted an estate tax deficiency of $2,854,729, as well as an accuracy-related penalty of $1,141,892.

At trial, the IRS contended that the decedent’s interest in PHC was $7,330,000 (about 20% less than on the notice of deficiency). The IRS’s expert opined that the decedent’s interest was $12,214,925 and then applied a 6% discount, because the decedent held a minority interest, and a 36% discount for lack of marketability of PHC’s nonpublic shares and for the BICG tax liability (in preparation for trial, this expert allocated 15% of this discount to the BICG tax). Overall, the IRS applied a 40% discount, for a total of $7,330,000. At trial, the estate used a different expert, who used the same capitalized-dividend approach as the original appraiser, but arrived at an estate value of $5,046,500, close to $2 million more than the amount reported on the estate tax return. This expert used a discount rate of 10.25%, a long-term growth rate of 5%, and the decedent’s share of PHC’s dividends in 2005, the year of the decedent’s death.

The Tax Court rejected the capitalized-dividend approach, explaining that this method is based on estimates about the future where even small variations in those estimates could have substantial effects on value. Instead, it chose to follow the NAV method, noting that actual market prices of publicly traded securities in PFC’s portfolio constituted a sounder method. Using this method, the court noted that discounts were ­appropriate for (1) the BICG tax; (2) the lack of marketability; and (3) the lack of control. The parties agreed about the discounts but disagreed how to measure them.

The decedent’s estate claimed a dollar-for-dollar discount ($18,113,083) for the unrealized BICG tax in PHC stock before calculating the decedent’s interest. The Tax Court, however, rejected the dollar-for-dollar reduction, stating that a 100% discount is not appropriate where triggering of the tax is subject to “indefinite postponement.” The court explained that the relevant inquiry was what price a willing buyer and willing seller would agree to taking into consideration PHC’s deferred tax liability.

To calculate the unrealized BICG discount, the Tax Court (1) used holding periods of 20 to 30 years, based on expert testimony that a potential investor would likely expect a complete portfolio turnover during such time; and (2) used rates of return similar to those used by the estate’s experts in the capitalization-of-dividend methods, as well as PHC’s historic rates of return. These calculations produced discounts within the range of $5.5 million to $9.6 million. Since the estate had offered no evidence on the length of a portfolio turnover and the IRS’s concession at trial fell comfortably at the middle of the range, the court accepted the IRS’s $7,817,106 discount as reasonable.

As to the discount for lack of control, the court found fault with both determinations (the estate picked the median/higher discount at 8%, while the IRS picked the mean/lower discount at 6%) and chose the mean 7.75% discount.

For the lack of marketability discount, the IRS’s expert used seven studies of restricted stock and pre-initial public offering transactions, ranging from a 26.4% to a 35.6% discount and chose the lowest discount of 26.4%, which it further reduced to 21% with no clear justifications. The estate’s expert, who had not provided independent studies, picked the top 35.6% discount, and the Tax Court averaged the high and low, establishing a 32.1% discount.

After applying the above discounts, the court found that the FMV of the decedent’s interest at death was $6,503,804. Since the estate had reported a value of $3,149,767, the court upheld a tax deficiency as well as the imposition of a 20% penalty for substantial-valuation understatement.

The Tax Court continues to reject the simple method of determining the discount for the BICG tax by calculating the BICG tax on the date of death and subtracting it from the value of the interest. Instead, it has followed its previous decisions in Estate of Jensen14 and Estate of Jelke15 by estimating how long it will take the “average investor” to turn over a similar portfolio and taking the present value of the tax liability using that turnover period. Nonetheless, it seems unfair to impose penalties here since the law is not clear. This case is appealable to the Third Circuit, which has not ruled on the issue.

Generation-Skipping Transfer Tax

Distribution From Trusts Created in 2010

In Letter Ruling 201352003, the IRS addressed various issues regarding the treatment of a trust created in 2010 for GST tax purposes. The decedent died in 2010, leaving part of an annuity she owned to a trust for the benefit of her grandchild. The executor of the decedent’s estate timely filed Form 8939, Allocation of Increase in Basis for Property Acquired From a Decedent, to make the election under Sec. 1022 to not be subject to estate tax and to allocate basis as provided by Sec. 1022. The executor attached Schedule R, Generation-Skipping Transfer Tax, to Form 8939 and allocated the decedent’s remaining GST exemption to other trusts established under her will. None of the decedent’s GST exemption was allocated to the trust.

Under the terms of the trust, the trustee will receive the required minimum distributions for a term based on the decedent’s life expectancy. During this term, the trustee is required to distribute annually to the grandchild the amounts paid to the trust. If the grandchild dies before the end of the annuity’s distribution period, the grandchild’s issue are entitled to the remaining distributions as beneficiaries of the trust. At the end of the distribution period, the trust will terminate, and the trustee will distribute any remaining assets outright to the current beneficiaries of the trust.

First, the IRS ruled that because all interests in the trust were held by individuals who were two or more generations below the generational assignment of the decedent, the trust was a skip person under Sec. 2613(a)(2). Second, the IRS ruled that because the transfer of the annuity was subject to estate tax and the trust was a skip person, the transfer of the annuity was a direct skip under Sec. 2612(c)(1), which defines a direct skip as a transfer subject to gift or estate tax of an interest in property to a skip person. Third, the IRS ruled that the decedent was the transferor of the annuity to the trust for GST tax purposes under Sec. 2652(a)(1)(A), which provides that the term “transferor” means, in the case of any property subject to the estate tax, the decedent.

Fourth, the IRS ruled on whether the GST tax resulting from the direct skip of the annuity to the trust is the value of the interest on the date of transfer multiplied by zero. Sec. 2623 provides that the taxable amount in the case of a direct skip is the value of the property the transferee received. Under Sec. 2624(b), in the case of a direct skip of property that is included in the transferor’s gross estate, the value of that property for GST tax purposes is its estate tax value. Sec. 2602 provides that the amount of the GST tax is the taxable amount multiplied by the applicable rate. Sec. 2641(a) provides that the applicable rate is the maximum estate tax rate multiplied by the inclusion ratio. The inclusion ratio is one minus the applicable fraction. The applicable fraction is a fraction, the numerator of which is the amount of GST exemption allocated to the trust (or to property transferred in a direct skip) and the denominator of which is the value of the property transferred to the trust or involved in the direct skip.

One should remember that in 2010 the estate tax was repealed, which also effectively repealed the GST tax. Under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 201016 (the Act), the estate tax was retroactively reinstated, but a decedent’s estate was allowed to elect to not be subject to the estate tax and instead be subject to the provisions of Sec. 1022. The Act also retroactively reinstated the GST tax. However, the Act provided that the applicable rate under Sec. 2641(a) for 2010 was zero, effectively eliminating the GST tax on any generation-skipping transfers in 2010.

The IRS noted that, under Secs. 2623 and 2624(b), the taxable amount of the direct skip is the value of the annuity that would have been included in the decedent’s estate if she were subject to estate tax. The executor of the decedent’s estate did not allocate any of the decedent’s GST exemption to the direct skip. Thus, the applicable fraction for GST tax purposes was 1. However, it noted that under Notice 2011-66 and the Act, the maximum estate tax rate in 2010 for GST tax purposes was deemed to be zero. Accordingly, the IRS ruled that the GST tax on the direct skip was zero.

Fifth, the IRS ruled on the generation assignment of the transferor. Sec. 2653(a) provides that if (1) there is a generation-skipping transfer of any property; and (2) immediately after the transfer the property is held in trust, for purposes of applying the GST tax to subsequent transfers from the portion of the trust attributable to that property, the trust will be treated as if the transferor of the property were assigned to the first generation above the highest generation of any person who has an interest in the trust immediately after the transfer. The IRS noted that the transfer of the annuity to the trust as a result of the decedent’s death was a direct skip. Therefore, it ruled that the trust is treated as if the decedent was assigned to the first generation above the highest generation of any person who had an interest in the trust immediately after the generation-skipping transfer.

Finally, the IRS ruled that periodic payments made after the date of transfer of the annuity to the trust and then from the trust to the grandchild while the grandchild was alive would not be subject to GST tax, because the decedent was moved to one generation above the grandchild.

This ruling confirms the result that occurred when individuals made transfers to a trust that was a direct skip in 2010. What this ruling did not state (presumably because it was not asked to) is what would happen if the grandchild dies before all periodic payments were made to the trust. In that case, the inclusion ratio is still 1, which means that the trust is not exempt from GST tax. Under the trust instrument, if the grandchild dies before the trust terminates, distributions are to be made to the grandchild’s descendants. Note that a distribution by the trust to a great-grandchild of the decedent would be a taxable distribution under Sec. 2612(b) because the transferor (the decedent) is two or more generations older than the transferee (the great-grandchild). Practitioners should remember that unless GST exemption was allocated to a transfer in trust in 2010, the trust may have a GST tax event if it has beneficiaries in the trust who are more than two generations younger than the transferor.

Footnotes

¹ Steinberg, 141 T.C. No. 8 (2014).

² Id., citing Succession of McCord, 461 F.3d 614 (5th Cir. 2006), rev’g 120 T.C. 358 (2003).

³ Robinette v. Helvering, 318 U.S. 184 (1943).

⁴ Van Alen, T.C. Memo. 2013-235.

⁵ Janis, 461 F.3d 1080 (9th Cir. 2006).

⁶ Estate of Olsen, T.C. Memo. 2014-58.

⁷ Estate of Bowers, 23 T.C. 911 (1955).

⁸ Compare Gowetz, 320 F.2d 874 (1st Cir. 1963) (post-death events may be considered), with Smith, 198 F.3d 515 (5th Cir. 1999) (post-death events may not be considered).

⁹ T.D. 9468.

¹⁰ Estate of Saunders, 745 F.3d 953 (9th Cir. 2014).

¹¹ Estate of Saunders, 136 T.C. No. 18 (2011).

¹² Regs. Sec. 20.2053-1(d)(4)(i). The Saunders court cited Regs. Sec. 20.2053-1(b)(3), but the regulations were amended and renumbered in 2009 (T.D. 9468).

¹³ Estate of Richmond, T.C. Memo. 2014-26.

¹⁴ Estate of Jensen, T.C. Memo. 2010-182.

¹⁵ Estate of Jelke, T.C. Memo. 2005-131, rev’d, 507 F.3d 1317 (11th Cir. 2007).

¹⁶ Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312.